Econ 357

1
Econ 357

• Prof. Jiahua Che
• 333-4580
• che_at_cba.uiuc.edu

2
Introduction

• Course subject
• Economics of transition, not Soviet economy
• What is economics of transition and what is
  economic transition
• Economic transition large-scale institutional
  change for countries moving from central planning
  to market economy

3
Introduction

• What is transition economics
• Institutional change in the context of former
  central planning economies
• Fundamentally about changing institutions from
  one place to another

4
Introduction

• What is institution?
• Social order or rule of games
• Institution ? Policy
• Examples of Institutions
• Markets
• Property rights
• Constitutions
• Social Norms

5
Introduction

• Why is institution important?
• Effective institutions raise benefits of
  cooperation in productive transactions
• Examples theft and pirates v.s. property rights

6
Introduction

• Why in the context of former central planning
  economies?
• Similar institutional structure to start with
• Adopted diverse transition strategies
• Had diverse transition experiences
• Brought about heated intellectual debates

7
Introduction

• Tools of Analysis
• Game theory, information economics, etc.
• Course Website
• http//ww.cba.uiuc.edu/che/econ357.htm

8
A Taste of Game Theory

• Two ways of representing strategic interactions
• Normal form game and extensive form game
• Normal form game
• Matrix consisting of players, actions, and
  payoffs
• Each player chooses actions simultaneously
• Actions are chosen optimally while anticipating
  others choice of actions strategies

9
A Taste of Game Theory

• Examples of normal form game
• Prisoners dilemma
• Player A
• Confess Not Confess
• Player B Confess -3, -3 0, -6
• Not Confess -6, 0 -1, -1

10
A Taste of Game Theory

• Examples of normal form game
• Driving on a street
• Player A
• Left Right
• Player B Left -3, -3 0, 0
• Right 0, 0 -3, -3

11
A Taste of Game Theory

• Examples of normal form game
• Matching pennies
• Player A
• Left Right
• Player B Left -1, 1 1, -1
• Right 1, -1 -1, 1

12
A Taste of Game Theory

• Solution concept
• (Pure Strategy) Nash equilibrium
• (1) each party chooses optimal actions given
  his/her anticipation of others choice of actions
• (2) the anticipations are consistent with the
  actual actions chosen

13
A Taste of Game Theory

• Examples of Nash equilibrium
• Prisoners dilemma
• Player A
• Confess Not Confess
• Player B Confess -3, -3 0, -6
• Not Confess -6, 0 -1, -1

14
A Taste of Game Theory

• Examples of Nash equilibrium
• Driving on a street
• Player A
• Left Right
• Player B Left -3, -3 0, 0
• Right 0, 0 -3, -3

15
A Taste of Game Theory

• Examples of Nash equilibrium
• Matching pennies
• Player A
• Left Right
• Player B Left -1, 1 1, -1
• Right 1, -1 -1, 1

16
A Taste of Game Theory

• Extensive form games
• Tree consisting of players, actions, and payoffs
• Players choose actions sequentially
• Each players actions make up branches of the
  tree, leading to actions of next player, .
• At the top (end) of the tree are the payoffs of
  all players as a consequence of actions taken
  along the branches that lead to the particular
  end

17
A Taste of Game Theory

• Examples of extensive form game
• Driving on a street sequentially

Player A
L
R
Player B
Player B
l
r
l
r
(-3, -3)
(0, 0)
(0, 0)
(-3, -3)
18
A Taste of Game Theory

• Extensive form games
• Subgame branches following a players move
  consist of a subtree, which is called subgame
• Example of subgame

Player A
L
R
Player B
Player B
l
r
l
r
(-3, -3)
(0, 0)
(-3, -3)
(0, 0)
19
A Taste of Game Theory

• Examples of subgame

Father
Not give allowance
(0, 0)
Give allowance
Son
Not use money well
Use money well
Father
Father
Give more
Give no more
Give more
Give no more
(7, 5)
(6, 6)
(8, 3)
(-1, 0)
20
A Taste of Game Theory

• Strategies
• Actions along every possible branches
• Example
• Father Give and give more if use well, but give
  no more if not use well
• Son Use well if give, not use well if not give
• Solution concept
• Subgame perfect equilibbrium Nash equilibrium of
  which the outcomes constitute of a Nash
  equilibrium in every subgame

21
A Taste of Game Theory

• Two Nash equilibria in Father-Son relation
• Father (Give, no more if use well, more if not
  use well) and Son (Not use well)
• Father (Give, no more if use well, no more if not
  use well) and Son (Use well)

22
A Taste of Game Theory

• Two Nash equilibria in Father-Son relation
• Father (Give, no more if use well, more if not
  use well) and Son (Not use well)

Father
(0, 0)
Give allowance
Not give allowance
Son
Not use the money well
Use the money well
Father
Father
Give more
Give no more
Give more
Give no more
(7, 5)
(6, 6)
(8, 3)
(-1, 0)
23
A Taste of Game Theory

• Two Nash equilibria in Father-Son relation
• Father (Give, no more if use well, no more if not
  use well) and Son (Use well)

Father
(0, 0)
Give allowance
Not give allowance
Son
Not use the money well
Use the money well
Father
Father
Give no more
Give more
Give no more
Give more
(7, 5)
(6, 6)
(8, 3)
(-1, 0)
24
A Taste of Game Theory

• Examples of subgame perfect equilibrium
• Only one subgame perfect equilibrium
• Father (Give, no more if use well, more if not
  use well) and Son (Not use well) subgame perfect
• Father (Give, no more if use well, no more if not
  use well) and Son (Use well) not subgame perfect

25
A Taste of Game Theory

• Examples of subgame perfect equilibrium
• Father (Give, no more if use well, more if not
  use well) and Son (Not use well) subgame perfect

Father
(0, 0)
Give allowance
Not give allowance
Son
Not use the money well
Use the money well
Father
Father
Give no more
Give more
Give no more
Give more
(7, 5)
(6, 6)
(8, 3)
(-1, 0)
26
A Taste of Game Theory

• Examples of subgame perfect equilibrium
• Father (Give, no more if use well, no more if not
  use well) and Son (Use well) not subgame perfect
  -- see the subgame encircled

Father
(0, 0)
Give allowance
Not give allowance
Son
Not use the money well
Use the money well
Father
Father
Give more
Give no more
Give more
Give no more
(7, 5)
(6, 6)
(8, 3)
(-1, 0)
27
A Taste of Game Theory

• Backward induction
• One easy way to find subgame perfect equilibrium
  is to use backward induction
• That is, to solve the game backwards, starting
  from the last subgames

28
A Taste of Game Theory

• Examples of backward induction Father-Son
  relation

Father
Not give allowance
(0, 0)
Give allowance
Son
Not use the money well
Use the money well
Father
Father
Give more
Give no more
Give more
Give no more
(7, 5)
(6, 6)
(8, 3)
(-1, 0)
29
A Taste of Game Theory

• The idea of lacking commitment
• Recall the two Nash equilibria in the Father-Son
  relation,
• In the equilibrium of Give but no more if not
  use well, , and Use well, Fathers equilibrium
  payoff is 6, and Sons is 7
• In the equilibrium of Gives and more if not use
  well, , and Not use well, Fathers equilibrium
  payoff is 3, and Sons is 8
• Father prefers the Nash equilibrium of Give but
  no more if not use well, , and Use well, but
  that is not subgame perfect
• In other words, Father cannot stick to (commit
  to) the strategy of Give but no more if not use
  well, , and Use well which subsequently makes
  him worse off

30
A Taste of Game Theory

• The idea of commitment
• Involves sticking to a strategy that is not
  optimal at some subgames, but the player is
  better off in equilibrium as a result
• Example Father sticks to the strategy of Give
  but no more if not use well, despite the fact
  that it is not optimal in one of the subgames

31
A Taste of Bargaining

• The problem of splitting a pie
• How will a pie be split between two people
• ½ and ½? 1/3 and 2/3? Or ¼ and ½?
• Many bargaining solutions
• Introducing Nash bargaining solution

32
A Taste of Bargaining

• Suppose
• Total worth of pie x
• If bargaining reaches agreement, pie is split
  between person 1 and person 2 in x1 and x2 such
  that x1 x2 x
• If bargaining does not reach agreement, person 1
  and person 2 get y1 and y2 respectively
• Nash bargaining solution
• The marginal values of reaching an agreement are
  equalized between person 1 and 2
• x1 y1 x2 y2, or
• x1 (X y1 y2)/2 and x2 (X y2 y1)/2

33
A Taste of Bargaining

• Example
• Pie worth x
• y1 y2 0
• Nash bargaining solution x1 x2 X/2

34
A Taste of Moral Hazard

• Principal v.s. agent
• Examples
• Employer/employees
• Constituents/government
• Investors/firm
• The problem of principal inducing right actions
  from agent
• Agents right action benefits principal
• Principal cannot observe (and verify) agents
  action
• Agent may not choose the right action

35
A Taste of Moral Hazard

• Example of employer inducing effort from
  employee
• Employees effort has a cost c(e)
• Employees effort yields output y(e)
• Efficient effort level e maximizes the social
  benefit minus social cost y(e) c(e)
• Had the employer been able to observe (and
  verify) effort, employer may contract with
  employee for effort e. The contract compensates
  him with c(e) if e e and penalizes him
  severely otherwise

36
A Taste of Moral Hazard

• Example of employer inducing effort from
  employee
• In reality, effort is not observable
• But output is
• Employer pays s lt 1 share of output
• Employee chooses effort e to maximize his private
  benefit private cost sy(e) c(e)

37
A Taste of Moral Hazard

• Example of employer inducing effort from
  employee

y(e)
c(e)
sy(e)
e
38
A Taste of Moral Hazard

• Illustration of incentives versus insurance

utility
Expected utility with eh
eh
el
effort
wage
output
Residual claimant
39
A Taste of Moral Hazard

• Illustration of incentives versus insurance

utility
Expected utility with eh
eh
el
effort
wage
output
Residual claimant
Share contract